Bonds with embedded options analysis

As introduced in Chapter 8, the most suitable measure of return for bonds with embedded options is known as option-adjusted spread or OAS. In this chapter, we show the analysis of bonds with embedded options, with particular focus on pricing methodology. 

If a bond s actual redemption date differs from the assumed one, its return computed this way is meaningless. The market, therefore, prefers to use other methods to calculate the return of callable bonds. The most common method is option-adjusted spread, or OAS, analysis. Although the discussion in this chapter centers on callable bonds, the principles enunciated apply to all bonds with embedded options. 

Chapter 11—The Analysis of Bonds with Embedded Options... 

The modified duration and convexity methods we have described are only suitable for use in the analysis of conventional fixed-income instruments with known fixed cash flows and maturity dates. They are not satisfactory for use with bonds that contain embedded options such as callable bonds or instruments with unknown final redemption dates such as mortgage-backed bonds. For these and other bonds that exhibit uncertainties in their cash flow pattern and redemption date, so-called option-adjusted measures are used. The most common of these is option-adjusted spread (OAS) and option-adjusted duration (OAD). The techniques were developed to allow for the uncertain cash flow structure of non-vanilla fixed-income instruments, and model the effect of the option element of such bonds. 

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